Pub Companies - Business and Enterprise Committee Contents

Memorandum submitted by David Morgan


  1.1  The profit assessment method of calculating rent should be carried out in accordance with national accounting standards and with knowledge, prudence and diligence (144).

  1.1.1  A significant proportion of my professional involvement of licensed and leisure property over the last 34 years, has been in respect of issues concerning rent review. As a Fellow of the Royal Institution of Chartered Surveyors, I regularly meet similarly qualified individuals acting specifically under the instructions of Pubcos that form the vast majority of the freeholders of the premises with which I am involved. The method of valuation adopted nationwide and by all specialist licensed property valuers, is that of the profits test in the assessment of open market rental, either upon review or lease renewal.

  1.1.2  The objective of the profits test is to effectively replicate the Trading and Profit and Loss Account of the hypothetical lessee in occupation with the exception of the input cost of the rent, thereby achieving a surplus or divisible balance which is split evenly between landlord and tenant as rent and tenantable remuneration. Rent review clause disregards are also infused which, to a degree, can make the valuation artificial if properly assimilated.

  1.1.3  The key to the profits test is the first input which is a genuine assessment of fair maintainable trade that should be achieved by a reasonably competent operator, having adequate market knowledge and operational skills and allowing for the expectation of consistency over the years until the next rent review, which would enable a test of genuine profitability to be made other than in only the first year.

  1.1.4  Having established that initial level, appropriate gross profit margins are then assessed based upon the specific on site circumstance of the outlet concerned. There is considerable variation in respect of gross profit margins, dependant upon immediate and direct competition. All items of income are analysed, namely drink, food, accommodation (if any), amusement machines and any other sources of income.

  1.1.5  From the assessed gross profit, a deduction is then made for establishment overhead expenditure excluding rent. Allowance should also be made for interest on working capital and for the notional acquisition of the inventory at in situ value, allowing for interest and capital being repaid monthly in arrears, usually over a maximum period of 10 years.

  1.1.6  The assessment of fair maintainable trade must include the relevant disregards set out in the rent review clause of the lease of the premises and in accordance with the Landlord and Tenant Act 1954 and subsequent legislation. (See 2. below).

  1.1.7  It is accepted that the various input factors are a matter of personal/professional interpretation and should as closely as possible, mirror relevant on site circumstance. It is acknowledged that some leases require the tenant in occupation to produce annual accounts and copies of VAT returns. In those instances, it has to be considered that the freeholder/landlord should have an accurate insight into the detail of the trading operations of the premises. Tenants in occupation can also volunteer their accounts, should they feel so minded.

  1.1.8  The calculation system, however, is open to abuse which very often occurs in the justification of a significant increase in rental upon either review or lease renewal by predicating "potential trade".

  1.1.9  As a result of my personal day-to-day involvement in rent review, experience indicates that the vast majority of initial rent assessments over-estimate fair maintainable trade, over-estimate gross profit margins and under-estimate establishment overhead expenditure. The resultant is always a significantly inflated divisible balance which if split evenly between parties, produces a similarly inflated rent justification.

  1.1.10  There can be in excess of 35 input factors in a profits rent calculation, all of which are accepted as being capable of having variation. National accounting standards require the detail of these input factors to be revealed much in the same way as a detailed Trading and Profit & Loss Account is prepared for taxation purposes.

  1.1.11  I have never found any such detail being included in the calculation exercise by the representatives of the Pubcos unless and if, third party referral is the only method of resolution of the rent review.

  1.1.12  I thus conclude that Recommendation 144 is not being adopted by any of the Chartered Surveyors as Pubco representatives that I regularly meet in the open market.

  1.2  A Comprehensive breakdown of how the rent is calculated should encompass and reveal the whole detail of the profit assessment and how the lease conditions have been interpreted (145).

  1.2.1  The first line of direct relationship between a Pubco and the supply tied lessee, is that of the Business Development Manager or Business Relationship Manager (BDM/BRM). In the days of brewery companies, these same individuals were known as "Divisional Managers" (DMs). None of the individuals concerned are Chartered Surveyors and some, but certainly not all, may have had direct trade experience as previous licensees.

  1.2.2  Rent reviews are generally perceived as adversarial. Starting off with this basic premise, the field of negotiation is widened considerably in that the basic viewpoint is that the Pubco (effectively a property company rather than a brewer), seeks to maximize rental income and enhance shareholder value. The tenant seeks to minimize any form of rent increase and thus ensure maximum operational profitability. Thus from the outset, the objectives of both parties are at opposite ends of a particular spectrum.

  1.2.3  I have not been involved in any initial exploratory discussions between tenant and BDM/BRM. I would not expect to be involved in these discussions as it is a natural aspiration of any tenant that he/she can successfully resolve a rent review negotiation. The Pubco representative approaches the situation with three aspirations:

    —  a sky-high rent demand that only an idiot might accept, but you never know;

    —  a middle ground rent review that has been authorized by his superiors as a settlement level that can be justified internally; and

    —  an ultimately lowest level settlement that is either accepted after significant negotiation processes have been exhausted, or by third party referral (arbitration/independent expert).

  1.2.4  There are thus three different levels of rental and initially obviously the highest is the only one that is quoted. Thus the process is adversarial.

  1.2.5  Anecdotal evidence leads me to conclude that there is never any paper justification for the first aspirational level of rental. If pressed and indeed it is accepted that a large number of tenants do not understand that they can request this information, the Pubco representative will never produce the justification for the first level of rental and just inform the tenant that the company has calculated the rent with their best interests at heart and they should just accept it, otherwise arbitration will cost thousands of pounds.

  1.2.6  If the initial negotiations are unsuccessful in producing an agreement, an "offer to settle" is then made with great reluctance, which is the second level of rental. Again, no paperwork is ever produced in the justification of that level unless specifically requested. The "theatre" of the reverse side of a laptop computer is always used as a "prop" by way of justification.

  1.2.7  Recent examples of ongoing rent negotiations in 2008 have produced exact replicas of the above scenario. They include:

    —  The Park Royal, Exeter—Enterprise Inns;

    —  The Filly Inn, Lymington—Punch;

    —  The Colliers Arms, Skewen—Enterprise Inns;

    —  The Black Horse, Chippenham—Enterprise Inns;

    —  The Sir Robert Peel, Kingston-on-Thames—Punch;

    —  The George, Wedmore—Admiral Taverns; and

    —  The Papermaker's Arms, Dartford—Wellington Pub Co.

  1.2.8  As a sample of the ongoing negotiations that occur in every single instance, I then formally requested by letter, the provision of a detailed justification of the rental assessment. In every instance, the justification was on an abbreviated form showing, for example, total sales ex rather than breaking down the sales into their constituent elements.

  1.2.9  Expenses are always shown as a single aggregate sum and are never broken down into individual input items. There is always a complete lack of detail as to how the summary income and expenses were achieved and until third party representation occurs, items such as working capital, ullage, wastage, purchase of the inventory and especially rent review disregards, are all ignored.

  1.2.10  A particular area of concern is the interpretation of lease clauses regarding rent review disregards. The three items of concern are:

    —  The disregard of tenantable goodwill.

    —  The disregard of the fact that the tenant has been in occupation.

    —  The disregard of structural works undertaken by the tenant at the tenant's expense with landlord's approval.

  1.2.11  I have never encountered a rent review negotiation that initially ever accepted that either of the first two items as outlined above should even be considered. In respect of the third item, a curious situation exists that is exploited by the Pubcos, should the situation arise. I deal with the issue of structural alterations in a separate heading below.

  1.3  The detailed profit assessment should form an addendum to leases to ensure transparency for any subsequent review or assignment (145).

  1.3.1  Since the issuance of the voluntary regulations by the TISC in 2004, there has been no discernable transparency in the detailed profit assessment in the many hundreds of rent review situations in which I have been personally involved. There has been no attempt by any Pubco to be transparent in the calculations even when forced to reveal this information. As outlined above, the very last thing that a BDM/BRM indicates to the tenant, is the method of calculation of the first (and highest) levels of rent in what again must be repeated, is an adversarial confrontation.

  1.4  The tied tenant should not be financially worse off than if they were free of tie (133).

  1.4.1  There is no obligation that a Chartered Surveyor should have to follow this method of logic. In the regulations that have been published in the RICS Valuation Standards (Jan 2008) and associated specific detailing as a result of the Trade Related Valuation Group and the publication "The Capital and Rental Valuation of Restaurants, Bars, Public Houses and Nightclubs in England, Wales and Scotland" (2003), there is no specific guidance as to how to formulate the obligation of equality. As a direct result of the lack of implementation either by the Pubcos or the RICS of the directive 133, there is a uniform misunderstanding within the body of Chartered Surveyors serving the Licensed Valuation market as to how the assessment of rent review should be undertaken in accordance with the TISC recommendations.

  1.4.2  There has been minimal attempt to differentiate between supply tied and supply free in the profits test calculation by the valuers acting for Pubcos. However, the prime source of comparable evidence has always been other supply tied public houses which has meant that there has been no reference or obligation to equate supply tie with supply free. From a personal standpoint, I have not attempted to force the issue in the absence of RICS guidance.

  1.4.3  Rent reviews are often undertaken with the benefit of selected comparables. The Pubco, however, has a manifestly unfair advantage as it has access to all of the comparables of its own estate, either locally or regionally. There is absolutely no opportunity for a tenant to have access to any of this database and from my personal experience it is never offered for the assistance of the tenant, other than to cherry-pick the very highest examples to prove a rent increase. In almost every instance, the comparators are of other tied houses with no direct comparisons to supply free leaseholds as in reality, these outlets are not contained within a supply tied Pubcos estate.

  1.4.4  From my direct experience, no Pubco valuers attempt to exercise the directive 133 in its correct understanding.

  1.5  Removal of upwards only rent reviews (151).

  1.5.1  Both Punch Taverns and Enterprise Inns have openly declared that in new leases, they would instigate upwards and downwards rent reviews. In this respect, new leases issued by both companies do indicate that at the fifth year on a quinquennial rent review basis, reviews will be undertaken on an upwards and downwards basis.

  1.5.2  However, I consider that a rent review actually means a proposed change in rent when the existing rent is reviewed by whatever means at whatever interval. Thus annual increases in accordance with the uplift of the Retail Prices Index (approximately 4.25% p.a. and rising) in the intervening five individual years prior to a quinquennial rent review, actually mean that the rent is being increased on a compounded basis by approximately 25% upwards only. It appears that this indexation goes completely against the core issue that every rent review should be upwards and downwards.

  1.5.3  Examples of this practice of upwards only reviews, exist as follows:

    —  In the last four years, both the Punch Growth Lease and the Enterprise Inns Retail Partnership Agreement state that there shall be annual rent increases in accordance with the Retail Prices Index. In all of its 80 or so years of established use, the Retail Prices Index has never seen anything other than upwards movement.

    —  As an example of the current practice, advertisements issued in July 2008 by Fleurets advertising new leases, indicated throughout all of the prospective lease documents under the heading "Tenure" "the property is available on a new Enterprise Inns lease for a term of between five and 25 years with a tie for drinks products. The rent will be stepped during the first year to a passing rent of £... pa thereafter which is subject to annual RPI increases and formal rent review after 5 years. Machine income is shared between Enterprise and the retailer".

  1.5.4  In the Enterprise Inns Retail Partnership Agreement which is now common throughout the entire estate and is the basis of lease agreements in the generality, Schedule 3 contained within that agreement, deals with rent reviews. Schedule 3, Section 1"Annual Reviews" states in paragraph 1.1 that the rent will be increased by the same percentage as the increase in the Retail Prices Index over the 12 month period since the previous annual review date. In paragraph 1.3, it clearly states: "if the index has decreased during the relevant 12 month period, the rent will remain the same". Quite simply, the rent is not capable of a downwards review until the fifth year.

  1.5.5  Schedule 3, paragraph 2.1 does not actually state in simplicity that the rent should be reviewed upwards and downwards. The paragraph actually states: "On each rent review date the rent will be reviewed to the market rent at that date". There is then reference to a hoped-for amicable negotiation and in the absence of that amicable settlement, reference to an independent surveyor. Having set out the detail of the reference to the independent surveyor, paragraph 2.5 states: "The reviewed rent may be higher or lower than the previous rent". Thus the clear inference is that if an amicable agreement is not reached, the only method of establishing market rent and thus a downwards rent review, is by recourse to third party or an independent surveyor.

  1.5.6  Even if the rental is obviously deemed to be reduced, it is the exception and certainly not the rule that a nil increase will be proposed, rather than a genuine long term (five year) reduction.

  1.5.7  It is appreciated that Enterprise Inns and Punch Taverns offer concessionary rentals. This should not be confused with a permanent downwards rent review cycle as a concessionary rent is exactly what it means, ie a short term alleviation of an existing high rent and a return back to that rent after a limited period of time. Certain circumstances also dictate that the concessionary rent must be repaid.

  1.5.8  Concessionary rent opportunities are sometimes offered under extremely constraining circumstances of ultra confidentiality and on the basis of a sacrifice of any supply free advantages which would then disappear for ever and the implementing of RPI indexation where previously it did not exist and further machine ties. Concessionary rents are only ever offered with considerable constraining further ties and obligations.

  1.6  Removal oF AWP tie (130).

  1.6.1  Since 2004 I have never encountered a situation where any Pubco has removed the AWP tie in any supply tied leasehold. This recommendation has been completely ignored.

  1.6.2 There is substantial evidence that there are considerable royalty payments paid by the amusement machine operators. For example, in the published accounts of Enterprise Inns 2007, the machine income was shown as £29 million as opposed to 2006 £26 million. This income could only come from royalties as Enterprise Inns do not operate a managed estate. If a machine tie did not exist, there would be no royalty payments and thus the on site machine rental payments to the supply tied lessee would be considerably lower than as at present.


  2.1  The opportunity exists in every supply tied lease for a rent to be determined by third party referral. This is usually to arbitration, although certain leases specifically state that independent expert shall be the only method of dispute resolution.

  2.2  The Pubcos have a considerable advantage in this situation in that they effectively have a bottomless cheque book in respect of fees, whereas the supply tied tenant is the exact opposite. I have first hand knowledge of BDMs/BRMs stating that if arbitration is sought, the tenant will incur many thousand pounds worth of expenditure and in every instance, the Pubco will win and their associated costs will also be added to the costs of the tenant. These scare tactics regrettably often have the effect of frightening a supply tied leaseholder into not seeking third party referral as a result of the threat of an horrendous cost burden.

  2.3  The situation is further exacerbated by the arbitrators appointed by the RICS, a large number of whom are Centrally London based, whose fees regularly exceed £300 an hour plus VAT. Thus for a very simple investigative progress prior to the actual event of arbitration submissions, could involve preliminary meetings with the arbitrator and preliminary issues that could easily utilise 10 hours of the arbitrator's chargeable time. Thus even before the arbitration effectively starts into a serious mode, over £3,000 of fees have been expended.

  2.4  To my personal knowledge, fear tactics are regularly used on a cost basis by BRMs/BDMs to dissuade supply tied licensees to even consider the standard legal remedy that is open to them, ie third party referral. I conclude that the above has a direct link to 1.2 above.


  3.1  A significant influence within the profits test valuation methodology for rent review purposes, is the consideration of structural alterations undertaken by the tenant at the tenant's expense with landlord's authorisation. Pubcos are singularly lax in explaining the definitive regulations that exist in respect of the establishment of evidence of structural alterations with landlord's consent. Although the situation may exist that the scheme of works is discussed with various levels of authority in the Pubco, that a planning application has been approved and that even the building surveyors of the Pubco have inspected and authorized the works themselves by verbal consent, I have never had a situation where the Pubco has explained in simple terms that a formal Licence of Alteration is actually required to stabilize the presence of the works concerned. Numerous examples exist of this situation which include the following sample premises:

    —  The Charcoal Burner, Sidcup—Scottish & Newcastle;

    —  The Filly Inn, Lymington—Punch Taverns;

    —  The George, Braunton—Enterprise Inns;

    —  The Rose & Crown, Dartford—Wellington Pub Co.;

    —  The Portobello Gold, Notting Hill—Enterprise Inns/Unique Pub Co.; and

    —  The Six Bells, Kidlington—Punch Taverns.

  3.2  The effect of not having a formal Licence of Alteration initially is dismissed by the Pubco rent review representative as evidence that the structural works should be included in the rent review. In every instance as outlined above, I have ensured that a retrospective Licence of Alteration has been applied for which has been, sometimes with great reluctance, easily approved.

  3.3  This is a further example of a complete lack of transparency and lack of good estate management which with the ignorance of the supply tied lessee, sometimes leads to an increased rent that under the rules of rent review and the disregards in the rent review clause of the lease, should not occur. I conclude that the basic principles of good Estate Management are not being followed which has an effect on the "Transparency" aspect of the TISC recommendations—see 1.3 above.


  4.1  As a result of the information set out above, I have to conclude that the voluntary recommendations of the TISC as issued in 2004 have been completely ignored by the Pubco operators, thereby ensuring the maximization of their rental income to the benefit of shareholders, institutional investors and debt funding.

22 September 2008

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